The Addiction to Scale…Why Growing Startups is Like Eating Donuts

mmmmm donuts

Addiction is an issue we deal with everyday. Some people are addicted to food, some to TV, some to working out (yes there are those weirdos out there), and some even to relaxing. We are constantly told how addiction is bad for us and in general every New Years, we all make resolutions to correct these habits. Yet, entrepreneurs are told something differently. They are told to grow quickly, capture market share, iterate on product rapidly, and to always focus on growth. They are told to embrace that addiction.

Growth is an addiction just like other addictions. Take donuts for instance: when you eat lots of them, it feels good; you get a sugar rush and that feels great; then you come down from the sugar and you feel terrible; the only thing that makes it better again is more consumption of donuts/sugar. The same analogy holds true for startups. When you get your first couple customers or team members it feels like you’re on cloud nine. When you launch with some PR, and you get your first 100 customers you jump for joy. When you turn on the marketing and sales spigots off of that PR, you and the rest of the team are popping bottles to celebrate. Then, the growth slows, everyone starts to scrutinize the metrics to see what’s happening and you begin to wonder what else you need to do to spur growth. This cycle continues until the next hit of sugar which fires off this whole thing again. This is part of being a startup and why it’s often referred to as a roller coaster ride…except the troughs and stomach churning lasts a lot longer than the ride.

So how can startups control their addictions. One way is to carefully analyze the capital needs of the business. If you take VC money or any Limited Partner-backed capital, you will need to scale and scale fast. The reason for this is that funds work just like startups. They invest in growth in order to pay a return to their shareholders that compensates those shareholders for the risk and opportunity cost they took in investing in you. Growth is always needed to increase the value of the business, but once you take venture capital then the speed of the growth needs to increase (if you’re a visual person than imagine a chart with an upward sloping curve, upon accepting VC capital that slope needs to steepen rapidly). Instead of just popping a candy a day, you need to pop Lamar Odom amounts of candy.

I am NOT advocating that taking VC money is bad. Rather, make sure to take the time to understand what advantages that capital will give you. VCs are excellent if you have a specific need like understanding how to build a product, needing to recruit specialized individuals, needing mentorship on building a business, and tons of other areas of expertise. These are all incredible benefits of VC money.

However, if it’s purely capital that you need, then think about other sources you can get them from. For example, family offices are long-term oriented investors and many individuals are long-term oriented if they believe in the vision. They can also have key industry contacts that can help you land those big customers that you need to scale. The “benefit” that so-called retail or individual investors have over professional public investors is that we don’t have to worry about monthly or even annual returns to justify our management fees. We just need to worry about our capital growing to pay for our future consumption. VCs don’t have the choice of being too long-term oriented as again that capital needs to be returned back to shareholders. A return of 500% is amazing! However, if that return takes 30 years then that investor may have been able to make a better return in other assets especially reinvesting dividends or cash flows that other assets may have returned. It’s why it’s important to do due diligence on all your investors, understand what they can offer outside of capital, and what their incentives are so you can see calculate the tradeoff you’re making.

Scaling capital efficiently is a hard thing. For one, if you’re bootstrapping the business then you are losing money out of your own pocket. Pressures can ramp up at home about getting a job that actual pays a salary to put the kids through college. When that first check comes in, you can finally feel relief that there’s no more money going out and you can focus on scaling. Just make sure you understand the expectations of that investor. To make a public market analogy, it’s the difference between Warren Buffett buying a stock hoping for a 5% annual return each year and Steve Cohen buying a stock hoping for a 200% return in 6 months.

Growing rapidly is not always a good thing. There are numerous startups that have failed because they expanded too quickly, ran out of capital, and then ran out of funding sources because VCs saw that the company’s growth rate had stalled. A classic example of this were all the on-demand startups that were created in 2013–2015. There were brilliant teams and ideas in these startups but what investors pushed for was rapid scale not efficient scale. Another example is Starbucks, when they increased store counts at warp speed in the early 2000s only to realize that having a Starbucks across from each other on the same street was probably not a winning strategy. This HBR article goes into much more detail.

Efficient scale means not always chasing growth. It means focusing on customer service and making sure each existing customer is happy. It means running lean and finding creative ways to acquire customers (Dollar Shave Club with their funny commercials, with their viral games — listen to this “This Week In Startups” episode if interested). It means thinking through your capital structure to make sure long-term aligned investors are backing you or the backers are providing you with the necessary help to get you to scale at the speed they want you to. It means understanding your cost of capital and utilizing debt for manufacturing or working capital lines when you can (if you’re running a consumer startup). Eventually, if your business is one that lends itself to low capital requirements and you are able to scale it efficiently, you’ll be able to write your own ticket in regards to the valuation, investors, and amount of capital that you take on.

The overall point of this post is this: think about rapid scale like you think about that donut. You weigh the cost benefit analysis of the short term awesomeness that you will feel vs the later drag and additional calories that you are consuming. Think the same way when approaching scale and accepting capital. Weigh the short term relief and elation against the long term effects on the business. Sometimes scaling rapidly with additional capital may be the right answer, but it’s worth considering before you take a bite of that donut.

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